Are markets just background noise? Should pension funds ignore political risks, overpriced assets and economic forecasts? Are all these just short-term effects that are hard to predict and best left to rich hedge fund managers? Should lesser mortals, like humble pension fund managers, focus just on the long term?

One pension fund’s recent experience offers answers to these questions.

Nationwide Pension Fund adopted a new long-term plan for its Cheshire and Derbyshire (C&D) section that called for a methodical adherence to automatically de-risking as threshold funding levels were reached. The result? C&D reached its objectives with years to spare, despite numerous market disruptions. Here’s how it happened.

A pension fund has only one clear objective – to pay the benefits due to its members, as and when they fall due. This is a long-term objective, even for closed defined benefit schemes. The strategies to deliver this objective generally focus on reducing risk and seeking a degree of certainty about meeting those future cash-flow requirements.

For the UK’s Nationwide Pension Fund, the trustees have agreed that being fully funded on a low dependency (LD) basis, with 100 per cent interest rate and inflation hedging, is a position that gives a strong degree of assurance that the fund should be able to meet its future benefit requirements without recourse to the sponsor.

For the purposes of the fund, the LD valuation assumes that liabilities are discounted at gilts plus 0.2 per cent, while the assets are expected to realise gilts plus 0.5 per cent. The excess 0.3 percentage points are there to cover service and management costs and changes to longevity.

This is not a perfect solution but it significantly reduces risk and the trustees are now more comfortable they can meet the obligations to members. It is certainly a more prudent position than the technical provisions calculations agreed upon with the sponsor, which discount liabilities at a higher level and assume a much greater expected return from assets.

The fund has two sections: Nationwide and the Cheshire and Derbyshire (C&D) section. The C&D is an amalgamation of two schemes blended into the fund following the merger of the Cheshire and Derbyshire building societies into Nationwide in 2009. C&D was reasonably funded then and following a payment of £15 million ($19 million) from the sponsor in 2010, it was fully funded on a TP basis, with £177 ($229 million) of assets.

A target for 2020

At this point, the fund was 40 per cent in equities, 47 per cent in gilts, 10 per cent in active corporate bonds and 3 per cent in alternatives. The trustees quickly agreed to focus on LD as the long-term target for the C&D section. A revised investment strategy was agreed upon that offered an expected return, which combined with a series of de-risking thresholds to provide a 50 per cent chance of reaching the LD target by 2020. This was mechanistic, with no regard for any views on markets beyond a long-term expected return from the assets.

The long-term plan commenced with a restructure into 30 per cent passive equities and 70 per cent passive gilts, and a series of incremental thresholds based on the funding level relative to the LD target. As these predetermined thresholds were reached, the portfolio would incrementally reduce equity exposure and increase the gilt exposure to improve the liability hedge.

Through the course of this strategy, only one further change was made; again, focused only on the long-term aim of achieving the LD position. This was to increase the liability hedging, through some modest leverage to some of the gilt exposure.

In October 2016, almost four years ahead of plan, the C&D reached its objective. It was fully funded on an LD basis and it was fully hedged for both inflation and interest rates. It had a 7.5 per cent allocation to passive equity and 92.5 per cent to gilts, linkers and AAA bonds. No views or opinions on rates, inflation, asset values, economic forecasts or political activity were given consideration on this journey. Again, the only strategy was automatically de-risking as threshold funding levels were reached. Since 2010, the sponsor has made no further contributions.

As this was happening, we experienced the tail end of the financial crisis, quantitative easing, negative interest rates, the European debt crisis, an oil price collapse, the Scottish referendum, Brexit and Trump, among other disruptions. None of these led to a change of direction. Indeed, in the context of the investment strategy, most of them weren’t even worthy of discussion. As at the end of March 2017, C&D had present liabilities, on an LD basis, of £329 million ($426 million) and assets of £333 million ($431 million). Having a long-term plan, sticking to it and putting aside any views on future markets for the sake of the long-term strategy paid off.

So, is worrying about the short term and trying to second guess markets worthwhile for pension fund trustees and their investment teams? If the C&D experience is anything to go on, perhaps a better use of a pension fund’s governance budget is to agree on a long-term objective, plan how to get there and focus on staying with the plan.

Mark Hedges is chief investment officer of the Nationwide Pension Fund in the UK.

Cbus Super executive manager, investment management, Trish Donohue, is publicity shy, while the fund’s executive manager, investment strategy, Kristian Fok, loves the limelight. It is just one of the many differences in their personalities and skill sets that have made them such a winning partnership for nearly two decades, held together by the glue of a shared sense of purpose.

The pair were joint winners of the prestigious Chief Investment Officer of the Year trophy at the Conexus Financial Superannuation Awards 2017, announced at a gala dinner at Ivy Ballroom in Sydney on March 9. Together, they share responsibility for the traditional chief investment officer role at the $A37 billion ($28 billion) construction industry fund.

“Kristian and I have actually been working together for 17 years,” Donohue said as the pair stood together on stage to accept the award on the night. “And while we don’t always agree, we do work well together. I put that down to a shared belief in always looking after the best interests of our members.”

Fok thanked Donohue for her vision in bringing him on board to help implement the fund’s ambitious growth strategy.

“I’d like to thank Trish for guiding me since I joined, and for understanding the enormous potential of the fund,” he said.

Donohue was the founding member of the Cbus investment team in 2000 and has led it ever since. A former Mercer consultant and actuarial analyst, she was originally hired by the fund to oversee its asset allocation strategy and external fund manager selection process.

In 2011, she spearheaded a major review of the fund’s investment strategy that led to the board approving a proposal to bring Fok, the fund’s long-time asset consultant from Frontier Advisors, in-house to share the chief investment officer role.

Fok’s former boss at Frontier, the firm’s inaugural managing director now its director of consulting, Fiona Trafford-Walker, has observed the dynamic between the Cbus co-CIOs up close.

“I’m sure they don’t always get along perfectly but they are really good at having healthy professional disagreements and I think they bring out the best in each other,” Trafford-Walker says. “It is definitely one of those situations where one plus one equals three. It is very refreshing to see two such senior people in the finance sector who are so much more focused on the long-term goals of the fund than their egos.”

In a crude sense, their respective responsibilities at the fund are split so that Fok now has primary oversight for investment strategy, while Donohue has primary oversight of implementation.

 

Insourcing plans

In August 2016, the Cbus board approved a plan Donohue and Fok assembled to lift the proportion of assets managed in-house from 8 per cent to 20 per cent within five years.

To support this strategy, the board also signed off on the hiring of an additional 25 internal investment staff. The new members of the internal team will mostly be specialists in equities and infrastructure.

As of March 2017, the growing Cbus investment team consists of 55 staff, who are researching and readying to take on mandates. Subsidiary Cbus Property, the fund’s wholly owned real estate developer, manages another 5 per cent of member assets.

Cbus Property employs roughly 35 staff and has created more than 70,000 construction jobs via its direct investment program since the business was created.

The Cbus Property portfolio exceeds $3.2 billion, with a further $5.0 billion of development work in hand.

In total, roughly 10 per cent of the fund’s total assets are managed in-house. Under the new insourcing strategy, and with total funds under management projected to swell to $50 billion by 2021, the internal investment teams are set to be collectively managing at least $10 billion within four years.

The real number could be significantly higher.

“Getting up to 20 per cent is a fairly conservative target. If you look at some of the big international pension funds, 30 per cent internal management is quite typical,” Fok says.

He was adamant that they are in no rush.

“We want to do this right, and let me be clear, we are not looking at removing all external managers. Although [we are already] finding new ways to work with our managers,” he explains. “Things we expect to do more of include co-investments, designing strategies and having them implemented by external managers, and non-discretionary mandates, where the manager produces opportunities and we say yay or nay.”

Donohue takes the lead on negotiating manager contracts and has already had success in reducing costs since the insourcing strategy was announced late last year. The strategy aims to allow the fund to lower member fees by 10 to 15 basis points within five years.

Fok says that estimate is now “looking conservative”.

As well as shaving off costs, these types of structures all make it possible for Cbus to exert more control in their fund manager relationships. By investing in fewer prepackaged products alongside other investors, Cbus is reducing the risk of managers being able to lock-up their members’ funds in the event of another market crisis.

De-risking the portfolio

Even without a significant downturn, the current investment outlook is challenging.

About two years ago, Cbus lowered the target return on its MySuper product by 25 basis points and there remains a risk this may have to be reviewed again, amid meagre global growth and ultra-low interest rates.

Over the past four years, Cbus has progressively reduced its exposures to private equity funds and listed equities, while increasing diversification.

Less headline grabbing than the insourcing strategy, but equally important, is Donohue and Fok’s ongoing effort to de-risk the portfolio.

Another outcome of the investment committee review back in 2011 that led to separating out the strategy and management teams was a change in the investment strategy to focus on absolute returns.

Donohue says this was a pivotal decision because it has freed up the investment team to care less about how they might be performing against rival funds in the short term.

“Peer risk…still needs to be acknowledged but it’s important that it is not allowed to be a big driver of investment decisions,” she says.

Peer risk refers to the risk of members choosing to take their money out of the fund during a period of relative underperformance.

“We are mindful that we are in a choice environment, so people can always switch if they feel the fund is not performing,” Donohue says. “But we don’t want that to be a driver because when you are comparing yourself to others you are always looking backwards.”

Of course, it is easy to say you don’t care about league tables when your fund is doing well. According to data from research house SuperRatings, Cbus MySuper has outperformed its peers over the past one, three, five, seven and 10 years.

Donohue says having a focus on absolute returns, rather than benchmark-relative returns, makes the most of the competitive advantages of strong liquidity and cash flow the fund gets from its default status by allowing it to maintain an allocation of about 40 per cent to unlisted assets.

Roughly 90 per cent of the membership is automatically signed up by their employer.

“The fund is very resilient. Inflows have grown significantly this past year, compared with recent years, and forward-looking stress testing indicates continued strong cash flows,” Donohue says.

She is mindful, however, of the risks associated with relying on this.

“We do a lot of work around liquidity stress-testing on a regular basis, to check how the portfolio would react to a number of elements that might affect liquidity, not just if there were changes to default, or another driver of changes to contribution rates, but also to downturns in markets and how that might affect our unlisted assets and other exposures,” she says.

Cbus is holding about 10 per cent of total assets in cash.

“That’s a higher allocation to cash than we would typically have but it is offset by a much lower than typical allocation to fixed income,” Fok says.

Roughly half the cash holdings are managed internally.

“Managing more cash internally, as well as lowering costs, gives us more control,” Fok explains. “In the GFC, lots of funds had their whole cash accounts locked up for periods.”

Donohue adds the fund has spread out the roll-out periods on their cash accounts to make the liquidity profile less lumpy.

Since the global financial crisis, and particularly in the past four years, the fund has expanded its use of sophisticated derivatives and futures overlays. This will allow it to move more quickly if there was ever a rising concern about any potential changes in the liquidity profile.

“There were a couple of lessons from the GFC and, in response, a lot of things have been repositioned and we continue to enhance the strategy’s flexibility,” Fok says. “The great thing about using options is it allows you to generate cash when you need it most.”

Property risks

Flexibility is important when such a high proportion of the fund is in unlisted assets.

The financial year ended June 2016 was a bumper period for Cbus Property, with the portfolio returning above 24 per cent for the 12 months. Over the past 10 years, the property fund has delivered an average annual return of nearly 17 per cent.

But many, including the Reserve Bank of Australia, have questioned the sustainability of the nation’s property boom, which raises the question of whether Cbus Property’s success is another potential source of future vulnerability for the fund.

Donohue and Fok argue that the direct investment structure makes Cbus less vulnerable in the event of a property market downturn than if it only invested via external property funds.

In the GFC, it became quite difficult to redeem out of a pooled property trust. But Cbus was able to liquidate a couple of small real-estate assets it owned directly to tap into cash.

A property downturn could be a double whammy for Cbus, as it might be accompanied by a drop in employer contributions on behalf of its construction industry members.

Someone Donohue and Fok turn to for advice on managing the risks associated with the fund’s property exposures is Cbus investment committee chair Stephen Dunne, who is a former chief executive of AMP Capital, one of the country’s biggest property investors.

Dunne joined the board as investment committee chair in November 2015, bringing a “different personal flavour” to governance than his predecessor Peter Kennedy.

“He’s put a five-page limit on all papers to the committee, which really forces us to be succinct, then questions us to drill down when needed,” Fok says.

Donohue says Dunne’s background at AMP Capital gives him great insights into what the fund is trying to achieve in building up an internal investment team.

As investment committee chair, he will no doubt also have curly questions about how Donohue and Fok are reviewing the performance of internal management teams.

As with external managers, those who do well can expect to see their allocated funds under management increase, while those who underperform long term will face the axe. Frontier has also been engaged to play a formal role in internal manager assessment.

 

conexust1f.flywheelstaging.com has partnered with the Thinking Ahead Institute on a regular column of investment insights to provoke thought and discussion among asset owners and managers around the world. This first column looks at ETFs and looks at when an ETF isn’t closely matched by its underlying components, liquidity can dry up, credit risks can emerge, and other factors can eat away at expected returns.  

Since their introduction in 1990 as a cost-effective means of index replication, exchange-traded funds (ETFs) have grown exponentially in number, variety and asset value.

At the end of 2007, before the main market impact of the global financial crisis, there were 1170 distinct ETFs with a total market value of $851 billion. Nine years on, at the end of 2016, the comparable numbers were 6625 funds valued at $3.546 trillion (according to sector researcher ETFGI) – an increase in assets of 317 per cent over the period.

ETFs’ rising popularity stems from several benefits they offer investors: they are cheap (the total expense ratio on State Street’s $139 billion SPDR fund is 9 basis points); they provide exposure to numerous asset classes, industries, geographies, factors and indeed combinations of these; and, in theory, because they are listed on exchanges, they offer a liquid means of building, hedging or shorting a position.

ETFs, however, are not without their risks.

Liquidity issues have emerged in the past, in periods of market stress, and remain contentious.

ETFs are structured to provide liquidity at two levels: through trading on the secondary market (investors trade shares in the ETF like a normal listed share); and through primary market liquidity, when they are liquidated or created from their underlying components.

It is instructive to distinguish between “plain vanilla” and exotic ETFs. In the former grouping, the instrument is closely matched by its underlying components, both in terms of composition and liquidity. Provided the ETF is not so large that its dealings have a market impact, plain vanilla ETFs have proved to be largely robust in the past. Capacity management (the market impact point) is the main issue to watch. Despite some temporary divergences from their underlying indices, these ETFs have, for the most part, been true to their stated objective of providing exposure to their underlying holdings.

In contrast, exotic ETFs are characterised by liquidity mismatches, leverage or both – and it is on these products that concerns tend to focus.

In the event of a sell-off in a high-yield ETF, for example, where liquidity in the underlying bonds has all but disappeared, gaps may emerge between the price of the ETF and that of the index it is trying to replicate.

In theory, the action of authorised participants (APs) in the marketplace should prevent this. APs are incentivised, but not obligated, to make a market in ETF shares and exploit arbitrage opportunities when the price of an ETF diverges from what underlies it. However, given that this involves a parallel trade in the underlying securities, APs may withdraw from the market when the liquidity of the underlying holdings dries up, or there is significant market volatility in the price of the ETF’s components.

Under these circumstances, the price of the ETF may diverge significantly from the stated index price, due to supply of and demand for the ETF in the secondary market.

Synthetic ETFs and counterparties

Synthetic ETFs, which are backed derivatives not physical securities, with investment banks as counterparties, also present some issues.

In many cases, the collateral the counterparties post to the derivative arrangement bears no relation to the assets of the underlying index being tracked. At times of stress, this mismatch exposes the ETF to credit risk from its counterparties.

Aversion to holding the collateral basket or dealing with the counterparty bank may cause APs to stop providing primary market liquidity – again giving rise to potential price discrepancies between the ETF and its components.

There are also market structural reasons why the performance of an ETF may not replicate its target index.

For example, in the case of the Volatility Index (VIX), the ETF will replicate its exposures using forward contracts on the index. Owing to the usual state of contango (upward slope) on the VIX futures curve, long-term holders of the ETF will gradually have their capital eroded, relative to the performance of the index, from paying away the roll yield of the futures.

Leveraged ETFs and rebalancing

Leveraged ETFs present other difficulties. Due to the requirement to rebalance leverage daily, investors using such ETFs to match their exposure to an index may find that after three days of market volatility they have not had the gains or losses they expected based on the performance of the index.

Then there are issues relating to ETF operational structures. Given the predictability of ETFs trading in the market when indices are rebalanced or future contracts are rolled over, there is some concern that they are easy targets for speculators, particularly in times of financial stress.

Ultimately, the outcomes from ETFs come down to how they are deployed. To determine this, we invoke our strategies for coping in a complex investment environment.

Investors need to be clear on their investment objective, have a clear understanding of the strategy they are deploying to achieve this, and be mindful of the other market participants trading in ETFs and how they might be looking to exploit structural features of the products.

 

Jeremy Spira is senior investment consultant at the Thinking Ahead Institute, an independent research team within Willis Towers Watson.

The Thinking Ahead Institute is a not-for-profit member organisation that was established to change investment for the benefit of the end saver. It has around 40 members, which account for over US$14 trillion in AuM and is administered by Willis Towers Watson’s Thinking Ahead Group, which was launched 15 years ago to challenge the status quo in investment and identify solutions to tomorrow’s problems.

No one can pretend the last few years have been boring. The period I’ve overseen since starting at the National Employment Savings Trust (NEST) has covered some of the most unusual events many investment professionals have seen in their careers.

From major shake-ups in politics, historically low interest rates, turbulent commodities markets and big shifts in long-term trends like climate change, we’ve coped with plenty over the last eight years. This is why it’s so important for us at NEST, as long-term investors, to have a strategic view of where we’re trying to go and not get blown off course by short-term events.

Having steadily diversified our portfolio as funds under management have grown, we’re doing all we can to mitigate the kind of turbulence we’ve seen over the last few years.

We’re invested in a wide range of asset classes, from equities to debt to property. We’ve just seeded a new climate-aware equities fund and are about to add high-yield bonds to our universe. It’s a pretty good range but it can’t stop there.

Our assets are going to continue growing exponentially over the next few years. We’re projected to be one of the biggest pension funds in the UK, if not internationally, by 2030. Our challenge is where to put the money. We need a large asset allocation toolbox to give us a choice of where to invest at any one time.

That’s why I’m going to be spending much time this year looking into alternative or private-market investments.

I want to know how we can access, within a defined contribution (DC) framework, things like infrastructure, private debt, private equity, renewable energy and timber.

We’ve got three main reasons for this. Firstly, we need the additional diversification. Secondly, we want the extra returns the illiquidity premium should provide. And thirdly, lower volatility assets like these sit well with our long-term strategic aims.

When we reach scale, our peers will be large, defined benefit or superannuation schemes, which are already far more diversified than most UK DC pension schemes.

It’s where we’re heading, and as we get larger, the constraints that often come with DC will be less of an issue. But we still need to work with the asset-management industry to access these alternative classes in ways that are cost effective.

Extra return, lower volatility

We know, for example, that we can get an extra return for money that’s tied up for a long time. And because we’ve got a lot of money coming in, we can take advantage of that. If you’re a 25-year-old and you’re in NEST, you don’t mind tying up your money for 10, 20, 30 years.

Most private market funds at the moment have a limited life, so after 10 or 15 years, the fund shuts and investors get paid out. We need longer time horizons than that and we need to be able to add an ongoing flow of money as our assets grow.

That means we’ll need customised funds that are focused on our specific requirements and can start small but essentially be an evergreen portfolio. These are long-term opportunities that make sense for long-term investors, like us.

Illiquid private-market assets also often have lower volatility, at least reported volatility, than more publicly traded securities.

Our long-term strategic aim is to increase members’ money as much as possible without exposing it to unnecessary volatility. We want to avoid volatility drag and, as best we can, manage sequencing risk. But, in particular, we want our members to feel confident in saving, and our research shows that excessive volatility is likely to discourage them.

Our members are relatively risk averse. They would probably be scared off by big falls in their pots. That’s particularly true for our younger members but the bottom line is, no one likes losing money.

Having a highly skilled and experienced in-house team is critical to allowing NEST to make these types of strategic investments in line with our members’ interests.

One of the first decisions we had to make when setting up NEST was what to outsource and what to do ourselves.

Academic evidence shows that the majority of the variation in returns comes from asset allocation, so it was important to us to keep that in-house, where we understand our members’ needs and expectations best. That’s ultimately why we’re here – to find the right solutions, so our members see steady returns, regardless of what’s happening around the world.

 Mark Fawcett is chief investment officer at NEST.

Over the past 10, 20 and 43 years, the South Dakota Investment Council (SDIC), which manages the benefits of more than 84,000 of the US state’s public-sector employees, has ranked in the top 1 per cent of public pension funds in terms of investment performance.

Strategy at the $10.5 billion fund is based on strict adherence to long-term strategies during underperforming periods and nurturing an expert internal team, state investment officer Matt Clark explains, in an interview from the fund’s Sioux Falls, South Dakota, headquarters.

“We are old-fashioned. We remember that first finance class at university and present value maths,” says Clark, who joined South Dakota in 2000 and made state investment officer in 2005. All investment begins with an assessment of an asset’s long-term fair value.

About two-thirds of assets are internally managed. Internal research focuses on estimating an asset’s future long-term cash flows, assessing the risk and discounting accordingly to calculate a fair present value.

“We apply this to all our portfolios and at asset-allocation level, adjusting the asset allocation based on relative valuations and targeted level risk,” Clark explains.

Next comes the discipline to wait for opportunities to arrive. Clark says investors have “cyclical and emotional time frames” that tend to fall into three-year periods.

“Over three years, something will change to become cheap, and something else will change to become expensive that you can then sell.”

Long-term fair value requires the patience to wait for opportunities that can take longer to appear.

“If we buy something early and the price keeps falling, it tests our fortitude and we find that we need to have everyone involved. It is scary when you buy something cheap and then it gets a lot cheaper, but you can never guarantee that this won’t happen.”

Contrarian moves in healthcare, real estate

Being contrarian is another strategy pillar. SDIC invests in assets it believes are undervalued from a long-term perspective. Due to the lack of opportunity in the current market, 24 per cent of South Dakota’s assets are in cash. Expensive equity has caused the fund to lower equity risk by placing its current risk target well below its benchmark. Unlike other investors, however, Clark says bonds are also expensive, thus he is “holding lots of cash”.

He explains: “Risk is expensive and bonds are expensive but we are confident that the market will come back to us if it is overvalued; if you wait long enough, it does come back to you.

“We look at what we can buy dirt cheap down the road and what will bring a tremendous return. We will not sit on cash forever. The alternative is to invest in something overvalued, and maybe make a small premium to cash, but overvalued markets are not calm. Markets do wake up at some point and re-price to give you a fair return. We view cash as dry powder waiting for a great opportunity.”

The contrarian theme is also illustrated in the high-yield/distressed debt allocation within SDIC’s fixed-income portfolio. Here, the fund recently pulled back in the belief that high yield is now overvalued.

In July 2015, the portfolio comprised a small allocation to subprime mortgages bought during the financial crisis and an internally managed holding of high-yield corporate junk bonds. Since then, the allocation has been steadily built up with investments that have included a sizeable allocation to energy debt, snapped up as it fell more than energy stocks when values in the sector plummeted.

“Energy had collapsed, and high yield had collapsed, so we increased our position from 1 per cent to 6 per cent and then 9 per cent of assets,” Clark recalls.

Today is a different story. Energy bonds and energy-related investments are no longer undervalued, so the fund is rebalancing the portfolio towards healthcare, investing in an assortment of related companies, including service providers and nursing homes.

“We thought healthcare was overvalued a year ago, when energy debt was so cheap. Many investors were staying away from energy when it was blowing up, and crowded into healthcare. Now energy has surged and there is pressure on healthcare,” he says. However, he cautions, “Healthcare isn’t straightforward. There are fundamental concerns about Obamacare.”

Strategy in real estate follows the same fundamental principles. SDIC’s real estate allocation has fallen to 8.25 per cent of assets under management due to recently sold investments and returned money.

“Real estate is not cheap like it was. In fact, it is more richly valued than anything else,” he says. In the current climate, he favours exposure to opportunistic real estate over core and stresses the importance of relationships with managers who have a track record of keeping their powder dry but are also prepared to invest up to the maximum in a downturn. The fund has key relationships with the Blackstone Group and Starwood Capital Group.

Clark favours arbitrage plays, like buying real estate investment trusts and breaking them up and selling them, or, if REITs are expensive, buying a building and packaging it up to sell as REITs. The fund is also seeking real estate debt opportunities through manager Lone Star in Europe.

“The financial crisis reinvigorated this asset class, but now opportunities in the US have dried up as bad loans in real estate have worked through.” It means distressed investors need to migrate overseas to opportunities in Europe.

“We like the flexibility to invest in any real estate anywhere, [having] patience and being prepared to do arbitrage,” he surmises.

Recruiting and retaining young locals

Clark has applied the long view to recruitment at SDIC as well; it’s a key contributor to the fund’s low costs. He has successfully nurtured, and managed to retain, top investment talent for the fund’s large internal management program, despite Sioux Falls’ location in the rural Midwestern United States, far from the bright lights.

“We never recruit from experienced talent. We don’t employ outsiders. Instead, we get the kids in the door,” he explains.

SDIC recruits through student intern programs, hand-picking the most gifted from South Dakota’s leading universities, with which SDIC has developed strong relationships, aided by Clark’s own status as a graduate of the University of South Dakota. Intensive training follows, and the students committed to staying in South Dakota are pursued most aggressively.

“These are the ones we want, and for them we are the only game in town,” Clark says. It is his job to gauge whether a candidate is “truly interested” in a long-term career in the community, and he gets it right so many times he can count on one hand those he has trained who have left.

Of course, SDIC ensures the incentives to stay are strong. A celebrated investment approach and unique in-house tools are two aspects of that. Leaving all that behind would be a wrench, says Clark, who likens employees’ attachment to the fund’s in-house tools and culture to Linus’s affection for his security blanket in Peanuts. The other strong incentive to stay is financial.

“Our compensation is the best of any public pension fund in the US,” he says, with SDIC offering “up to 200 per cent of base salary in incentives based entirely on performance”.

It is fitting that one of the projects he has been most closely involved in during recent years is re-engineering the fund’s risk and asset allocations into modular components, abandoning a complicated optimisation model. This simplification is allowing the fund to get its “younger people” into the asset allocation process for the first time.

“It is an interesting process,” he says, though he is typically modest about the impact it will have when completed. “I like having lots of pistons in the engine because lots of what we do doesn’t work. If we do lots of things, some things will work.”

Asset owners have rapidly scaled up their response to climate change to protect portfolios, but they have yet to catch up to the asset managers’ progress on a range of key activities, an annual benchmark report reveals.

The Asset Owners Disclosure Project (AODP) Global Climate 500 Index assesses the world’s 500 largest asset owners – representing more than $40 trillion in assets under management – on how well they disclose and manage climate risks that could affect retirement savings and other long-term investments.

This year, for the first time, AODP also surveyed the world’s 50 largest asset managers, which handle $43 trillion on behalf of their clients – representing more than 70 per cent of assets under management worldwide.

Globally, more investors are factoring climate risk into their decision-making. However, the report finds that although asset owners are making “rapid” progress, asset managers are ahead on a range of key activities.

It shows, for example, that 90 per cent of asset managers have incorporated climate change into their policy frameworks, compared with 42 per cent of asset owners. While the asset owners’ percentage is lower, it has doubled since last year.

The proportion of asset owners with staff focused on integrating climate risk into their investment has increased by more than a third, to 18 per cent. Again, asset managers are a long way ahead, as 68 per cent of those surveyed have dedicated staff.

One-fifth of asset managers calculate portfolio carbon emissions, while 13 per cent of asset owners do this – up from 10 per cent last year. Also, 12 per cent of asset managers assess the risk of stranded assets in their portfolio; 6 per cent of asset owners do this – up from 5 per cent last year.

AODP founder and chief executive Julian Poulter says: “Climate change is becoming a central part of risk management around the world, and will transcend short-term political setbacks such as moves by the Trump administration in the US to roll back action on climate change. Once investors adopt prudent risk-management practices, they will not unlearn them.”

Despite the upward trends, 200 asset owners and three asset managers showed no evidence of taking any action to tackle climate risk.

The AODP index assesses asset owners and managers on governance and strategy, portfolio risk management, and metrics and targets. Institutions are graded from AAA (the highest) to A ‘leaders’, down to D-rated institutions taking their first steps on climate risk. Those providing no evidence of action are rated X and classed as ‘laggards’.

In 2017, AODP made some changes to its methodology for constructing the rankings.

“While the underlying questions remain the same as last year,” the report states, “we have calibrated our assessment categories with the [Financial Stability Board] recommendations, to help asset owners and asset managers prepare for potential future reporting requirements. This alignment provides institutional investors with reporting consistency, trend analysis and an effective framework to implement the strategies required to meet – and perhaps more importantly exceed – the FSB’s expected guidelines.”